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Principles of Macroeconomics Summary Notes on Inflation Inflation is a chronic increase in average prices over time. In recent years, the concern of Wall Street (the major businesses) and the government (more specifically the Federal Reserve Bank who is charged with the task of price stability) has been deflation. Deflation exists when prices decrease. This has certainly been the case in the housing market. From 2007 to 2009, housing prices decreased by 20 percent,1 there were over two million foreclosures per year,2 and over 85 percent of the metropolitan areas witnessed decreases in home prices, causing millions to lose equity.3 http://www.standardandpoors.com/indices/sp-case-shiller-home-priceindices/en/us/?indexId=spusa-cashpidff--p-us---Over the last couple of years, deflation has ceased to be as much of a concern. Housing prices are still falling, but other prices are rising. The Federal Reserve Bank have also injected some money into the economy which causes upward pressure on prices. What is the current rate of inflation? 1 National Association of Realtors 2009 Source if information RealityTrac 3 Ibid 3 2 http://www.bls.gov/cpi/ Consumer Price Index - All Urban Consumers What are the measures of inflation? Consumer Price Index changes in the cost of goods that consumers’ purchase. A price index that measures the cost of a fixed basket of consumer goods and services and compares the cost of this basket in one time period with its cost in some base period. Changes in the CPI are used to measure inflation. http://www.usinflationcalculator.com/inflation/current-inflation-rates/ http://www.usinflationcalculator.com/inflation/consumer-price-index-and-annualpercent-changes-from-1913-to-2008/ Producer Price Index changes in the prices of goods that producers’ purchase http://www.bls.gov/news.release/ppi.nr0.htm GDP Deflator or implicit price deflator, is a measure of the level of prices of all new, domestically produced, final goods and services in an economy. Medical Price Index changes in the price of medical goods and services. Since 1983, Medical Prices have risen over 400 percent. See the table below, what costs 100 in 1983 now cost $435. The changes for the market basket used to measure CPI shows that what costs $100 in 1983 now costs $236. Clearly, medical cost are rising more than other cost! Actual annual increases in the MPI over the past decade are shown in Table 1. 2 Table 1 What is deflation? A decrease in prices over time. That sounds good unless you are the seller of the product What are the negative effects of inflation on the economy? 1. decreases purchasing power – real wages. If prices rise by more than wages then real wages (purchasing power) decreases. 2. increases interest rates – Fisher’s Theory http://www.crestmontresearch.com/docs/i-rate-relationship.pdf What do these graphs show? Interest rates are tied to inflation rates. When inflation rises interest rates rise. That means credit card rates rise, auto loan rates rise, mortgage rates rise, student loan rates rise 3. creates uncertainty 4. bracket creep 5. international trade is tied with the value of the dollar. Explanation… Inflation is tied to the value of the dollar. A weak dollar makes goods produced in the US more affordable to foreigners. A strong dollar makes foreign goods more affordable to US consumers and businesses. Oil is prices in dollars. A strong dollar reduces oil prices for us in the US! What is the difference between real wages and nominal wages? Television sets overtime 1954 Westinghouse: $1295 (15") 1960 RCA: $495 (21") 1972 Emerson: $358 (18") 1982 Sylvania: $430 (19") 1996 Samsung: $340 (19") 2015 Samsung $149.99 (19”) 720p / LED HDTV 1960 1970 1980 1990 2000 2014 in dollars Nominal Wages* 93 141 277 447 680 1035 in dollars Price Index** 29.6 38.8 82.4 130.7 172.2 236 Real Wage $ 314.19 $ 363.40 $ 336.17 $ 342.00 $ 394.89 $ 438.56 *average weekly wage in covered employment ** CPI using 1983 base year Fun Fact! In 1960 it took the wages from 8 days of work to buy a television set. By 2015 it took the wages from 9:00 am to 2:30 pm to buy a television that is much better quality than the one produced in 1960!! What Things Cost in 1940: Car: $800 Gasoline: 18 cents/gal House: $6,550 Bread: 8 cents/loaf Milk: 34 cents/gal Postage Stamp: 3 cents Stock Market: 131 Average Annual Salary: $1,900 Minimum Wage: 30 cents per hour What Things Cost in 1959: Car: $2,200 Gasoline: 30 cents/gal House: $18,500 Bread: 20 cents/loaf Milk: $1.01/gal Postage Stamp: 4 cents Stock Market: 679 Average Annual Salary: $5,500 Minimum Wage: $1.00 per hour What Things Cost in 1980: Car: $5,413 Gasoline: 1.03 cents/gal House: $86,159 Bread: 48 cents/loaf Milk: $1.60/gal Postage Stamp: 15 cents Stock Market: 1100 Average Annual Salary: $14,352 Minimum Wage: $3.10 per hour http://www.inthe80s.com/prices.shtml Life then versus life now. http://workforcesecurity.doleta.gov/unemploy/hb394/hndbkrpt.asp 1940 Average weekly wages $27.02 1960 average weekly wages $93.30 1980 average weekly wages $276.89 2012 Average weekly wage $940.49 http://www.census.gov/hhes/www/housing/census/historic/values.html 1940 average home prices $2,938 1960 average home prices $11,900 1980 average home prices $47,200 2012 average home prices $218,600* *Median prices http://www.census.gov/construction/nrs/pdf/uspricemon.pdf The current American lives a very different life than the former American. What are the causes of inflation? Types of Inflation There are three main types of inflation: 1. Demand-pull inflation 2. Cost-push inflation 3. Hyperinflation Demand-Pull Inflation Figure 6-1 illustrates the concept of demand-pull inflation. Consider the demand for automobiles. If economic growth is strong, consumer income rises and the demand for cars such as the Toyota Camry’s and other popular models increases, as shown graphically. The rightward shift in the demand curve for automobiles drives up auto prices from Po to P1. This is known as demand-pull inflation: inflation resulting from the increased demand for goods and services throughout the economy. As this example shows, demand-pull inflation is generally driven by purchases of final goods and services. Cost-Push Inflation Figure 6-2 shows the idea behind cost-push inflation: higher production costs shift the supply curve to the left, causing prices to rise. Following our previous example, as Toyota and other automobile producers increase their output to meet a surge in demand, they must pay higher prices for inputs such as steel. In addition, they will add extra production shifts, incurring increased overtime expenses for labor. As a result, the cost of producing an auto increases. Higher production costs cause the supply curve to shift inward resulting in higher prices for automobiles. The main cause of cost-push inflation is increasing prices of inputs used in production. Cost Push Examples Micro Applications A potential leading indicator of cost-push, or supply-side, inflation is commodity prices. Economists track the prices of various commodities, from oil to gold. As the prices of inputs such as copper rise, the prices of outputs such as home wiring and plumbing will soon follow. To date there is no consensus as to which commodities to track and their relative weights (importance) in a commodity price basket. Although commodity prices do respond positively to increases in demand, they are also subject to noneconomic influences such as mining strikes and oil embargoes. For this reason commodity prices can undergo large swings for nondemand reasons, and their individual price spikes may not be a prolonged contributor to future inflation. Furthermore, raw materials represent only about 10% of total production costs, easily dwarfed by labor, which accounts for approximately 70% of the cost of production in the United States (a country with relatively capital-intensive production processes). Commodities can yield an important leading indicator of future inflation, when their prices rise due to greater demand. Since the effects of short-lived supply problems (which are more easily compensated for) are hard to separate, commodities have failed to become a consistent and reliable leading indicator of future inflation. Macro Applications On a larger, macroeconomic scale, cost-push inflation is a result of supply-side shocks. A well-known example of a supply-side shock was the OPEC oil embargoes during the early and late 1970s. The economic effect of the oil embargoes was a surge in the price of oil and other petroleum products. Higher oil prices caused energy prices to soar, which translated into electricity price spikes. As the producers of goods and services saw their utility bills climb, the increased cost of production led to a scenario as shown above by energy-intensive industries such as steel. Higher production costs led to a contraction of supply and higher prices of inputs and consumer goods. Hyperinflation As unappealing as demand-pull and cost-push inflation sound, they are a drop in the bucket compared to the grandest of all inflations, hyperinflation. The best definition of hyperinflation is price increases that are so out of control as to make the concept of inflation meaningless. For example, in Germany between January 1922 and November 1923 (less than two years!) the average price level increased by a factor of about 20 billion. The German hyperinflation had its roots in the Treaty of Versailles, where the victorious allied nations imposed impossible war "reparation" payments on Germany. Faced with financial debts beyond its economic capacity to generate the required amount of payment, the German government started printing money to meet its obligations. As you see in this course, a major cause of inflation is printing money in large quantities, which can lead to an inflationary spiral. During the hyperinflation, German workers would be paid in three shifts during the day. For example, after working the morning shift, workers would race to spend their fresh salary, which would be worthless within another few hours. There are pictures of children building play forts with bricks of worthless currency. Observers told stories of how Germans would order two beers at once, fearing that beer prices would rise before they finished their first one. Another story does have a silver lining. If a person purchased a bottle of wine, they could sell the empty bottle the next day for more than the purchase price - wine included. As you might imagine, the value of domestically held savings was wiped out, and the German middle class eroded substantially. The economic chaos opened up an opportunity for Hitler and his brown shirts to take over, leading Germany and the world into World War II. Fortunately, the victorious allies learned their lesson and helped rebuild the devastated Axis governments through the Marshall Plan. The Money Supply and the Price Level in Russia, 1993-1998 Consumer Price Level (millions of rubles) Year (1993=100) Money Supply QuasiMoney 1993 100.0 23,881 17,102 1994 974.62 68,544 61,187 1995 3970.41 151,627 124,514 1996 11808.39 192,402 164,922 1997 17425.64 270,602 192,246 1998 19973.27 344,113 289,514 http://www.sjsu.edu/faculty/watkins/brazilinfl.htm Brazil went through the same issue. How does the US compare to other countries? http://stats.oecd.org/Index.aspx?querytype=view&queryname=221 http://www.visualeconomics.com/wp-content/uploads/2009/12/worldinflation.jpg How does productivity effect inflation? Some sample inflation questions Calculating Inflation Monthly Costs in Charlotte Housing Utilities Car Insurance Entertainment Electronic Goods Food 2012 2000 390 349 130 70 120 322 2013 2150 430 369 148 81 104 338